Borrowing during periods of policy uncertainty: The role of foreign lenders

Abstract

Despite the documented detrimental effect of policy uncertainty on borrowing costs, there is no evidence on the potential role of cross border borrowings during such periods. In this study, we test two hypotheses on the potential role of foreign lenders during periods of high policy uncertainty. The first is the common exposure hypothesis, which predicts that domestic lenders pass their uncertainty exposure on to borrowing firms by charging higher loan spreads. Hence, foreign lenders without such exposure could be able to help dispel policy uncertainty. The second is the information cost hypothesis, which predicts that foreign lenders compensate for information asymmetry when lending in host countries by charging high loan spreads, which suggests potential higher costs of foreign borrowing. We find that foreign lenders who are not simultaneously exposed to policy uncertainty charge lower loan spreads than domestic lenders, which supports the common exposure hypothesis. Additional analysis reveals that the two hypotheses complement each other, as the documented effect is particularly pronounced for foreign lenders who are exposed to lower information asymmetry. The findings of the study shed some light on the role of financial market integration during periods of high policy uncertainty.